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david berman

Globe and Mail columnist David Berman.The Globe and Mail

Pot stocks have a certain appeal: They're new, they're different and they invite puns.

As investments, though, their appeal is harder to see. Valuations have risen to the point where it is only natural to wonder if the sector has inflated to bubbly levels, leaving new investors with a big question: Have you thought this through?

The infatuation with pot stocks began in 2014, when Tweed Marijuana Inc. – now Canopy Growth Corp. – became the first publicly traded producer with a government licence to sell the drug to approved patients.

The listing gave the industry the credibility it needed, attracting more companies to go public. Now there are enough pot-related stocks to make an exchange-traded fund. The Horizons Medical Marijuana Life Sciences ETF, consisting of 16 stocks with relatively large market capitalizations, went live on Wednesday.

Early investors in these pot stocks have made a killing, particularly in the past year, as infatuation with the sector really kicked in.

Canopy has risen 308 per cent, to the end of March. Aphria Inc. is up 383 per cent, Aurora Cannabis Inc. is up 432 per cent and Maple Leaf Green World Inc. is up 408 per cent.

Ottawa's plan to legalize the recreational use of marijuana, perhaps as early as next year, is no doubt driving some of these gains. But investors can also point to strong growth.

In its fiscal third quarter, Canopy said that its revenue rose 180 per cent, to $9.7-million, year-over-year. The company made a profit of nearly $3-million, representing a sharp reversal from a loss of $3.3-million during the same quarter last year.

Extend this sort of growth over a decade or so, and you have the makings of a thriving company, a valuable stock – and a hot sector.

Trouble is, the enthusiasm driving pot stocks is now miles ahead of reality, making the sector look like a dangerously inflated bubble with absurd valuations.

Let's take another look at Canopy, somewhat famous for its "WEED" ticker symbol. According to Bloomberg, the stock trades at 36-times sales, which is completely out of line with the 1.8 price-to-sales ratio for the S&P/TSX composite index.

As for that profit last quarter, it amounts to 2 cents per share. Even if the company produced a profit of 10 cents in 2018 – which is well above expectations – the stock's price-to-earnings ratio would be about 100, or about five times higher than the index (which itself is hardly cheap).

Some companies can grow into their high valuations, particularly those with strong competitive advantages. Tesla Inc., Netflix Inc. and Amazon.com Inc. come to mind.

But marijuana companies face at least two formidable challenges. New competitors can emerge, given that barriers to entry appear to be low. As well, these companies must convince consumers that their products can't be found elsewhere.

Sure, as bubbles go, this is small. It seems insignificant next to the dot-com bubble of the 1990s, the U.S. housing bubble of a decade ago and the Japanese bubble of the 1980s – all of which evaporated billions of dollars and brought down economies when they burst.

By comparison, even the big players in the Horizons Medical Marijuana Life Sciences ETF have relatively small market capitalization, ranging between $77-million and $1.6-billion. That's not enough to worry economists.

Investors, though, need to be on their toes.

The only sure way to identify a speculative bubble is to wait until it has burst. A good alternative? Look for the telltale signs: Crazy valuations, unsustainable rallies and plenty of hype.

Marijuana stocks have all three signs, and they are flashing neon right now.

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